Peritus’ Tim Gramatovich was quoted in the article, “Some companies won’t survive the oil meltdown,” by Matt Egan of CNN Money, December 16, 2014.
According to the EIA, U.S. crude oil imports averaged about 7.3 million barrels per day last week with Canadian barrels making up 3.2 million barrels of the total.1 U.S. commercial reserves increased by 1.9 million barrels week over week where total inventories fell 3.7 million barrels2 versus expectations of a build of 950,000.3 Are we at the beginnings of a rebalancing of the market? Possibly. New well permits across the top three fields in the U.S. have reportedly fallen off dramatically in November, and given the dynamics of shale production, this may quickly impair U.S. production growth forecasts.
It’s no secret that oil’s plummet from above $100/bbl to current levels has hit the North American oil industry hard. Both stocks and bond prices of E&P (exploration and production) and service companies in Canada and the U.S. have dropped markedly over the last couple of months. That said, the medium-term impacts of this price decline will likely not be felt quite so equally across the North American or, indeed, the global market due to fundamental differences in business models, existing leverage and currency arbitrages that certain producers enjoy.
We have discussed the challenges we see with the shale oil business model many times, specifically that the exceptionally high decline rates and the production costs lead to an expensive treadmill that we believe many of these companies can never get off of. Declines in U.S. shale are as high as 90-95% in the first two years.4 A sustainable production model in our view is not one that requires a company to race like mad to punch more holes in the ground just to maintain existing production. That said, we acknowledge that there is definitely money to be made in tight oil and we like these plays at the project level, where payouts are quick and the wells are financed with the right term of debt (short-term, commensurate with the life of the project). But we do not support them as businesses that we can lend money to over the long term due to excessive capex requirements that lead to chronic negative free cash flow.
Numerous theories exist about why the Saudis elected not to cut production at the November 27th meeting. Ours quite simply is that the rapidly growing U.S. shale production in recent years, coupled with the return of missing barrels from the likes of Iraq and Libya, threw the market out of whack and resulted in a crude oversupply. The production adds from these regions have had the follow on consequence of creating an increasingly competitive market in Asia, where the Saudis have the vast majority of their market share. In an effort to protect market share and rebalance the market, the Kingdom has taken very deliberate action to target high cost shale producers at the margin who have used leverage to finance their operations. Do we think that the Russians, the rest of OPEC and the majors around the globe are involved in this? Yes we do.
The main opposition to this concept comes from the other main conspiracy theory that is floating around these days that is centered on Russia and goes like this: the Saudis and the U.S. are in collusion to punish Putin for his actions in the Ukraine. The Saudis support the U.S. in this because the quid pro quo here is that the Saudi’s get U.S. support in Middle East affairs, where ISIS is running amuck, and the U.S. gets to teach Putin a lesson. It’s not a bad theory, it just fails to recognize some economic realities that we have long known and have been exploiting, such as the currency differentials impacting the actual realized prices in various geographies.
The fate of resource based economies like Canada rest in the strength of commodity prices. The Canadian dollar tends to rise and fall with oil as a result of this. As a consequence, Canadian producers have been partially insulated by the decline in the price of oil because of the fact they sell oil in US dollars (USD) but incur costs in Canadian dollars (CAD). Thus at a USD/CAD exchange of $1.135, which is where it approximately stands today, a Canadian producer is realizing a price of C$75.52 on WTI of $67.43 (in US$).6
Russia is also highly dependent on oil revenues for its economy. Much has been written and said about Russia’s need of $100 oil to balance its budget. Indeed, recent reports peg the impact of oil’s price decline as costing Russia about $100 billion per year. However, like Canada’s loonie, the ruble has devalued to the dollar along with the fall in the price of oil. The chart below represents the ruble’s decline over recent months in relation to the USD.7
When one considers the impact of the price decline on regional Russian crudes such as the East Siberian Pacific Ocean oil8, when coupled with the currency arbitrage of a falling ruble, it is clear the Russians aren’t the intended victim in this Saudi murder mystery. In fact, at the quoted exchange rates and a price of $69.32 for this type of crude at the time of writing, Russian producers are actually realizing a ruble price today that is only 4.5-5% less than what they were receiving in early June of this year.9 Yes, over the longer term a falling ruble will have far wider reaching impacts on the Russian economy and purchasing power, but one still has to ask the question of whether it is logical to think that making the whole world suffer just to show Putin he can’t misbehave is realistic?
Marginal production out of high cost sources like shale are clearly the easiest and most logical target of the Kingdom’s recent decision not to cut production. By killing off some of the shale production it’s a win for nearly everyone but the U.S. Eventually, we’d expect formerly displaced light oil imports will return to the U.S. and market share competition in places such as Asia will ease up.
At Peritus we have long been of the opinion that many shale producer business models are flawed and unsustainable, and now that oil has fallen so precipitously, cracks in already stretched balance sheets are starting to appear. Energy represents 18% of the U.S. high yield market.10 Capital expenditures commonly exceeded cash flows of many shale producers at $100/bbl. How do you think they will they fare at $70 with wells that decline by 90-95% every two years?
While calm waters are a ways off for the oil markets and along the way there will undoubtedly continue to be unexpected supply disruptions out of the Middle East and Africa that will add volatility to prices, we expect the medium to longer term supply and demand dynamics will lead to a rebound in oil prices, benefiting those that are able to withstand these shorter-term price dynamics.
1 Source: U.S. Energy Information Administration, Weekly Petroleum Status Report, week ending 11/28/14 (November 2008).
2 Source: U.S. Energy Information Administration, Weekly Petroleum Status Report, week ending 11/28/14 (November 2008).
3 Data based on expectations from Bloomberg.
4 Determination based on Peritus’ research.
5 Prices and exchange rates as of 12/3/14.
6 Prices and exchange rates as of 12/3/14.
7 Data sourced from Bloomberg, covers the period 3/31/14 to 12/3/14.
8 Data sourced from Bloomberg, covers the period 3/31/14 to 12/4/14.
9 Prices and currency rate as of 12/3/14.
10 This statistic for the J.P. Morgan High Yield Index, constrained. Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield and Leveraged Loan Research, November 21, 2014, p. 6.
It has been a poorly kept secret that I am among the biggest skeptics in the planet as it relates to this whole US “energy independence” fantasy. As a credit investor, I have been “no bid” on the entire US E&P business. This was not an easy thing to sidestep as “energy” as a sub-set is by far the largest component of the various high yield indexes representing around 18%1. Interestingly, we have been severely punished for our exposures to “energy.” We recently wrote an assessment of our oil and overall energy exposures, entitled “Rockefeller Part II” (available at http://advisorshares.com/fund/hyld2). Most importantly we discuss our rationale for owning what we own. While we have been beaten up in certain holdings within our portfolios, we have confidence in our specific allocations to the sector, and expect that oil will ultimately move dramatically higher, which we would expect could lead to our investments to not only coming back but prospering in the coming years.
We have written chapter and verse on what we want to be long in the oil space: long lived production and reserves, reasonable decline rates, moderate leverage and exposure primarily to heavy oil. We have found this in many companies in the Western Canadian basin and will continue to focus our attention there. The Gulf Coast (and the rest of the world) needs heavy oil and Venezuela and Mexico, the traditional providers of this crude, are declining rapidly. This has already created increased demand for the heavy oil from Canada (versus the light oil largely produced domestically). The plunging Canadian dollar and tightening heavy/light differentials have offset some of the price decline realized by many Canadian producers.
We see the US shale basins as almost the mirror opposite of what we are looking for. We are watching bond prices of these E&P (exploration and production) companies plunge over the past few days but remain completely and totally disinterested in what we would view as falling knives. But our disinterest has nothing to do with the price of oil. Our issue with all of it has to do with the confusion of a single word. And that word is “of” vs “on.” Stated more completely investors are going to be given a lesson on the difference between return “of” capital versus return “on” capital. How many times must we listen to the word “breakeven” as it relates to these producers? Candidly, I have no idea what is meant by breakeven.
My take is straightforward. There is no free cash flow generation in any of these shale E&P “companies” thatI have reviewed. Let’s use the simplest definition of free cash flow we can: EBITDA less interest less capital expenditures. If you run those numbers they will frighten you. We believe that the business modelswere broken from the start because capital expenditures dwarf EBITDA generation. This is because tight oil/shale wells have decline curves that are around two years. This means that production declines by 90-95% every two years3. We don’t see them as businesses, they are projects. We believe that financing these so called companies using long term debt (5-7 years) will end badly. These companies were bleeding cash with oil at $100 but nobody was looking at the numbers; there was just an assumption that everyone makes money at high oil prices. But oil’s price collapse has woken up the herd and they are beginning to look under the hood.
Now let’s deal with some realities. If you are an income investor you are most likely invested in the energy game whether you know it or not. This includes high yield bonds and loans along with the very popular MLPs (master limited partnerships). It is imperative that you know what you own and why you own it. Most importantly, businesses need to generate a return on capital not a return of capital. When financing markets close, the return of capital game ends. And my take is that it has ended.
While we love to buy value created by some stress, I have no interest in putting on positions in “companies” that aren’t companies. We see no safety in numbers here: owning a whole bunch of names in the same space gets you to the same place. And to us that place is default. But more concerning should be recovery values. If these “companies” limp along for another few years (likely) and continue to drill out the inventory (sweet spots aren’t that large), what is left at the end of the day? Rocks in Fargo I guess. Perhaps it unravels sooner. If you ratchet back capital expenditures to preserve liquidity your production collapses along with cash flows. You can see the endless treadmill that many of these guys are on because two year declines won’t allow you to build a business.
Did I expect oil to trade down $40 a barrel? I did not. Do I think oil prices stay down for an extended period of time? No I am not in that camp. In fact I am a raging bull on oil markets. Demand is growing (which is likely to speed up with lower prices) and the world’s production of conventional oil is stagnant to declining. That leaves unconventional production to fill in the gap. This production will need to come from oilsands, deep water projects and even these tight basins and all of this needs higher prices to cover the cost of production.
Buying low and selling high is a main tenant in investing. We see that selective energy names need to be bought as we expect investors with a multi-year year horizon will do very well as we believe oil is ultimately set to increase. For us, this does not include US shale names.
1 This statistic for the J.P. Morgan High Yield Index, constrained. Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update,” J.P. Morgan North American High Yield and Leveraged Loan Research, November 21, 2014, p. 6.
2 Peritus manages the Peritus High Yield ETF (ticker: HYLD). Fund information, including fund prospectus and other detail is available at http://advisorshares.com/fund/hyld. Fund distributed by Foreside Fund Services, LLC.
3 Determination based on Peritus’ research.
Peritus was mentioned in the article, “An Active ETF Approach to Junk Bonds” by ETF Trends, December 3, 2014.
As active managers, we embrace both a top down and bottom up investment philosophy as we look for opportunities for investment. One such potential opportunity we are seeing from more of a top down, thematic approach is in gold. Before anyone thinks I have lost it, I am simply talking about bonds in some of the lower cost miners. Always remember the advantage of being a debt investor: you aren’t looking for or in need of a quick trade or turnaround. What you are looking for are survivors. We only need our companies to keep the lights on at the bottom of the cycle. Those companies that do this often capture huge rewards. Darwin was a questionable biologist, but should have won the Nobel Prize in economics. Darwinian economics (“survival of the fittest”) often plays out in down cycles. Those that make it through can end up with pricing power and increased market share, and thrive in the long-term. Think of auto suppliers who survived the terrible period from 2005-2009. They have been making a great deal of hay in the last five years.
I am not a gold bug in any way and am not looking for some type of inflation protection. What I am interested in is gold’s potential reaction to the ultimate reality that global Central Bankers, in my opinion, are in fact nothing more than government bureaucrats. The insanity of thinking that they can control economic outcomes or steer the globe is utter insanity. At what point will people begin to lose faith in the whole process? I have often mumbled to myself that gold makes no sense and has no fundamental or industrial value. And fiat (paper) currency does? Throughout the history of man, gold was a store of value and medium of exchange. It wasn’t until Nixon ended Bretton Woods for good in 1971 that the world did not link some portion of their money supply to gold. China, Russia, India, Korea and Japan combined hold around two-thirds of all foreign exchange reserves (total US dollar foreign exchange reserves are estimated to be around $12 trillion by the IMF1). As the following article indicates, it seems like Russia and China are not exactly enamored with the option of holding their reserves in the US dollar, and Germany and France are already way ahead of them:2
Attending the St. Petersburg International Economic Forum in May, Putin stressed to reporters that it is important to deposit gold and currency reserves in a rational and secure way. Many market observers expect Russia to increase its gold holdings over the next few years, as the ratio of gold in its foreign reserves is still smaller than those of France and Germany, whose gold holdings are around 60% of total foreign reserves….China, which has been critical of the sanctions against Russia and has strengthened economic ties with the country, has also been increasing its gold holdings in recent years. Some market watchers predict that if China and Russia, which have adopted a confrontational approach to Western countries, further increase their gold holdings, the dollar’s status as a key currency could be shaken.
Nikkei Asian Review, http://asia.nikkei.com
Since a large percentage of the remaining reserves are held by countries considered the developing world it seems to me that these cultures may be much more comfortable with gold over paper. Given the soaring dollar, the collapsing euro and China’s failure to make the yuan a reserve currency, perhaps we all will.
What is important is how we might express this in our portfolios. This is not a speculative “trade,” nor is it a hedge. In studying a number of miners it reminds me a great deal of the pharmaceutical or biotechnology industry. In the case of pharma, product development often takes a decade or more of research and development and then trials. Once a product is approved, the margins are enormous because all of that R&D has been expensed (or capitalized) in prior years. So it is a distorted picture. Think the same of mining. A decade to get approvals, assays, coring and then mining infrastructure in place. Then you mine and sell it and operating costs are not that large.
It is interesting how the media continues to talk about how gold has lost its luster and has fallen precipitously. But it really hasn’t. It began the year at $1,200 and is around the same level3. Another point I find very interesting is that bond yields for the major and intermediate gold producers remain very low. This gets to my point about the profitability of this industry and the cash generating ability once developed. We have in our gun sights a couple of bonds in this space that offer what we see as a good yield. We are seeing these companies generate free cash flow and expect it will continue at levels nicely below current prices, so a very good credit investment from our perspective but with the potential upside we see coming from a changing world. Many gold miners will continue shrinking capacity as prices fall below “sustaining costs.” These sustaining costs include capital investments (maintenance capital expenditures) to maintain a flat reserve level. But as is the case for many commodity producers, there is about a decade worth of production available with minimal additional spending necessary, allowing for plenty of cash generation potential. Ironically this lack of growth is a huge positive for credit investors.
What many investors don’t grasp is that you can actively position businesses and industries in a fixed income portfolio the same way you can equities. The difference is that we get paid every day as our securities accrue interest and we have finite outcomes via stated maturities, which helps us remain patient.4 We don’t require earnings growth or beating Street estimates to make money. We just need the companies to pay their bills and generate some free cash flow, what we see as perfect for the subdued economic environment we see going forward.
For more on our thoughts on current market conditions and outlook going forward, see our recent piece, “Rome is Burning.”
1 Currency Composition of the Official Foreign Exchange Reserves, www.imf.org. Data as of Q2 2014.
2Tanaka, Takayuki, “Russia boosts gold reserves to soften sanctions,” Nikkei Asian Review, http://asia.nikkei.com, October 7, 2014.
3 Data sourced from Bloomberg, as of October 28, 2014.
4 Bonds and loans have a stated maturity date as the ultimately outcome, barring a security default. However, there may be reasons that a bond or loan is taken out or redeemed earlier, such as due to early calls or tenders at premium prices. Actual results may differ materially from the stated maturity.
Tim Gramatovich, Chief Investment Officer of Peritus, will be a guest on Fox Business Networks’ “Willis Report” today, Monday, November 17th at 5:35pm ET
Peritus was mentioned in the article “Buy These 3 ETFs for Active Management Strategies,” by Eric Dutram of Zachs Research.
Volatility has seemed to be the trend in markets over the past couple months. It was just a few weeks ago that we saw equity markets getting crushed, only to roar back and actually finish up for the month of October and back near all-time highs. It makes no sense to us that investors have no problem dealing with volatility in stocks, “investing for the long run,” as the stock market has historically gone up, but with the high yield asset class, we often see the “risk on” or “risk off” mentality, meaning investors think they should either be fully invested or out of the market altogether.
In reality, over the long-run high yield bonds have actually performed relatively equivalent to equities (as measured by the S&P 500 index), with nearly half of the volatility, or “risk,” as measured by the standard deviation. This has led to risk adjusted out performance (return/risk) over the history of the high yield market:1
People seem to often view the high yield market as an all or nothing trade, with its attractiveness merely based on short-term measures. Yet we believe its true attractiveness is the steady income it provides, in both up and down markets, and potential for price appreciation/capital gains. As we look at the high yield market today, the recent re-pricing of the market over the past few months has created what we see as exceedingly attractive opportunities for yield, as well as discounts (pricing below par and call prices) that we have not seen in some time in many names, allowing for more potential opportunities to realize capital gains.
What many investors don’t grasp is that you can actively position businesses and industries in a fixed income portfolio the same way you can equities. The difference is that we get paid every day as our securities accrue interest and we have finite outcomes via stated maturities2, which helps us remain patient. So why not collect the regular income generated (coupon payments) and enjoy a market that has historically had nearly half the volatility as as the stock market?
1 Credit Suisse High Yield Index data from Credit Suisse. S&P 500 numbers based on total returns. Calculations based on monthly returns and standard deviation is calculated by annualizing monthly returns. Return/risk is based on annualized total return/annualized standard deviation. The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. Use the links below to download index data and constituents. The S&P 500® is a market-value weighted index of 500 selected common stocks, most of which are listed on the New York Stock Exchange. It is widely recognized as representative of the equity market in general. Values based on monthly compounding.
2 Bonds and loans have stated maturity dates as the ultimately outcome, barring a security default. However, there may be reasons that a bond or loan is taken out earlier, such as due to early calls or tenders at premium prices. Actual results may differ materially from the stated maturity.
Tim Gramatovich, Chief Investment Officer of Peritus, will be a guest on Fox Business Networks’ “Opening Bell with Maria Bartiromo” on Wednesday, November 12th at 9am ET. Tim will be discussing the current state of the energy market.
The concurrent storms in energy and the secondary bond/loan markets have tested our mettle. However, we believe that both of these will pass as quickly as they came, but provide fantastic entry points for thoughtful investors as there is a hard cold reality every investor is facing: interest rates (yields) remain paltry and we expect will continue to for the foreseeable future. We ultimately expect the underlying fundamentals in certain segments of the energy sector will be realized and now are seeing yields and discounts (to par) in the broader high yield market that we have not seen for some time. This compares to an equity market where we expect valuations to struggle to move higher in a world of slowing growth. For more on our thoughts about financial markets and outlook, click here to see our latest piece, “Rome is Burning.”